The Inefficiency of the Market Isn’t an Open Question

In an article on the front page of Tuesday’s Times, Binyamin Appelbaum did a nice job of highlighting the difference in views between Robert Shiller and Eugene Fama, who shared this year’s economics Nobel memorial prize with Lars Peter Hansen. But there’s a danger that some readers may come away from the article, and other news coverage of the prize, with the impression that the issue of whether financial markets are efficient remains unsettled. It isn’t. After living through a stock-market bubble and a credit bubble in the past decade and a half, we can be quite sure that financial markets are sometimes chronically inefficient. The only outstanding question is how far this inefficiency extends.

Discussing the Nobel committee’s decision to honor Shiller and Fama in the same year, Appelbaum quotes Justin Wolfers, an economist at the University of Michigan: “It encapsulates the state of modern economics,” Wolfers says. “We have big important questions that remain largely open, and we have giants bringing evidence to bear. And the answer turns out to be more complicated than markets are efficient—or markets are inefficient.” On top of teaching and doing his own research, Wolfers, through his columns at Bloomberg View and his regular presence on Twitter, does a yeoman’s job in helping to educate the public about economics. I often learn from him. But I fear he erred in this instance. Neither Fama nor Shiller are intellectual giants. They are both smart, empirically-minded professors who did influential and important work. Putting them on a pedestal serves no purpose. Also, as I said in opening, the question of financial-market efficiency is no longer an open one. In anything but the narrowest technical sense, which conflates efficiency with predictability, it has been settled in the negative.

Part of the problem is how financial economists define efficiency. In most areas of economics, efficiency is defined in terms of how well markets allocate resources. If a given market allocates them in a way that leaves it impossible to increase the welfare of one person without lowering the welfare of at least one other person, the market is said to be “Pareto efficient.” One of the big achievements of twentieth-century economics was in showing how, under certain highly restrictive conditions, a free-market economy can produce a Pareto-efficient outcome.

Since the nineteen-sixties, when Fama got his start, financial market efficiency has been defined rather differently. According to Fama’s definition, which quickly became the standard one, a financial market is “weak-form efficient” if prices reflect all the past information that is relevant to the market, such as the history of price movements. The market is “semi-strong-form efficient” if it reflects all past and current public information. And it is “strong-form efficient” if it reflects all the public and private information.

Since the stock market can’t talk, we can’t ask it if the price of I.B.M.’s stock fully reflects the latest developments at I.B.M.’s research facilities. (Even if markets could talk, they might not tell us the truth.) Rather than gauging market efficiency directly, economists have concentrated on testing certain narrower theories that appear to be corollaries of efficiency. For example, weak-form efficiency implies that technical analysis (“chartism”) can’t be used to beat the market. Strong-form efficiency suggests that all fundamental stock analysis, of the sort frequently carried out in brokerage and fund-management firms, is pointless. Since efficient markets reflect all information practically instantaneously, the deductions the analysts are making are already reflected in the price.

It was clear from the very beginning that this notion of efficiency is problematic. On a theoretical level, it can be, at best, a rough approximation. If markets are strong-form efficient, it is a waste of time and effort for anybody to pore over quarterly reports or articles about industry trends. But if nobody does this sort of information-processing, how does new information get incorporated in prices? As Joseph Stiglitz and Sanford Grossman pointed out way back in 1975, a perfectly efficient market is an impossibility.

On a more practical level, too, this notion of efficiency is problematic. If prices in financial markets already reflect all the pertinent information, they should move only in reaction to news, which, by definition, is unexpected. Thus prices should move randomly—not predictably. Very many empirical studies, including some carried out by Fama in his later years, suggest that they don’t, or not fully. On a short-term basis, there is a lot of noise in the data, but there is also a mild amount of persistency: if a stock went up yesterday and the day before, it’s got a slightly better than fifty per cent chance of going up today. (Statisticians call this “serial correlation.”) Over longer periods—months and years—there are other regularities that investors, at least theoretically, could use to beat the market. Small stocks tend to outperform large-cap stocks. Value stocks—ones with low price-to-book ratios—tend to outperform growth stocks. Stocks that underperform the market for long stretches tend to rebound and outperform.

Moving from individual securities to the over-all market, how does efficiency hold up? Not very well. In many markets, not just the stock market, prices tend to overshoot in one direction or another and, eventually, revert to the mean. Occasionally, this phenomena takes on extreme forms. During the late nineteen-nineties, there was the tech bubble, during which the market’s information-processing machine virtually ceased to function: for a time, virtually any company with the suffix “.com” attached to its name could issue stock at a very high price. And just a few years later, there was a credit bubble, during which yields on risky debt fell to absurd levels. More recently, we’ve seen spikes in the prices of oil, gold, copper, and other commodities that were hard to justify on the basis of fundamentals.

Speculative bubbles represent glaring violations of informational efficiency, and they also violate allocative efficiency, which is much more important. The ultimate purpose of financial markets is to share risk, finance productive investment, and help the economy grow. But in recent years, we have seen instances where the markets have amplified risk, financed a ton of unproductive investment—such as empty housing developments in Florida, Ireland, and Spain—and helped bring on the deepest recession since the nineteen-thirties. Looked at it in this context, the proposition that markets are efficient can seem like a poor joke.

It is true that quite what causes the widespread market failures in finance remains an open question. (Perhaps that is what Wolfers was driving at.) Various explanations have been put forward for the recent proliferation of bubbles. Some of them are based on irrational exuberance (or irrational pessimism). Broadly speaking, this is Shiller’s favored candidate. Other explanations retain the rationality assumption, for at least some investors, and focus on structural barriers that prevent the exploitation of profitable arbitrage opportunities, such as limits on short sales and solvency constraints. (As the old saying about the perils of contrarian investing goes, the market can stay irrational for longer than you can remain solvent.) There are also explanations that hark back to Keynes’s beauty-contest model, in which perfectly rational investors choose to run with the crowd rather than reacting to fundamentals. Still other explanations focus on overly loose monetary policy.

I would argue that during the tech and credit bubbles all of these things were at work. In the late nineties, many retail investors in the stock market simply got caught up in the frenzy. But many sophisticated hedge funds took a calculated gamble to surf the bubble rather than betting against it. Similarly, during the credit bubble, the big banks were willing players in what some of them viewed as a game of pass-the-parcel. (Recall the famous July 2007 quote from Chuck Prince, then the chairman of Citigroup: “As long as the music is playing, you’ve got to get up and dance.”) In both bubbles, the presence of trend-following behavior generated a positive feedback process, which explains why prices moved in such an extreme fashion.

As I pointed out yesterday, Fama and some of his fellow efficient-markets believers reacted to these events in a way that combined denial with elaborate rationalization. In a 2010 interview with me, Fama refused to accept that the markets went loopy, and he even questioned whether there was such a thing as a bubble. In recounting extreme movements in the market, he pointed to sharp but unexplained (and unobservable) shifts in investors’ risk tolerance as an explanation that was consistent with efficiency. His second defense was to fall back on the difficulty in predicting market movements. He dismissed Shiller’s warnings about the stock market in the late nineties, suggesting that some of them were issued as early as 1996, four years before the bust.

Nobody could dispute that market movements are hard to forecast. But just because it is tough to tell what a market is going to do doesn’t mean it is efficient in any meaningful sense. Let’s say the Fed announced tomorrow that it had decided to inflate a stock-market bubble and that it would stick with its policy mix of near-zero interest rates and quantitative easing until it succeeded in its aim. If this happened, we could be pretty sure that the market would go up, but how far, and for how long? If we lined up a hundred of the top economists in the world, Shiller and Fama included, and asked them for predictions, few if any of them would get the answer exactly right. But would that mean that the market was acting in an efficient manner? In a very narrow and technical sense, perhaps. In a broader sense, surely not.

To be fair to Wolfers, I should also point to a Bloomberg View column he co-wrote, which was entitled “Nobel Prize Shows Both Wisdom and Madness of Crowds,” and which points to some of the problems attending the efficient-markets theory. “With a little latitude one could summarize this prize as suggesting that financial markets are efficient (Fama), except when they’re not (Shiller), and that we have empirical evidence to prove it (Hansen),” the article notes wryly. However, its conclusion is equivocal:

There are also deeper lessons: This stuff is hard. Social science progresses slowly. Most important, we are still learning how and when financial markets generate wealth and provide economic stability and when they are a casino destabilizing the economy.

I agree with part of that. If I were trying to come up with a defense of financial markets, I would say that that they are often highly inefficient, inequitable, and wasteful; but they are also very productive, and, perhaps, their wastefulness is an inevitable concomitant of their role in financing new and untested innovations. For every ten Webvans, you get an Amazon.com.

That’s roughly the argument that Bill Janeway, the venture capitalist and Keynesian economist, makes in his original and thought-provoking book, “Doing Capitalism in the Innovation Economy: Markets, Speculation and the State.” It’s a defensible story—much more persuasive than simply falling back on Alan Greenspan’s point that economics is hard and bubbles are tough to spot. That dog won’t hunt. In early 2000, when 3Com floated its Palm computing subsidiary on the Nasdaq, the market put such a high price on the new issue that it implied that the parent company, which retained a big stake in Palm, had a negative stock-market valuation. Was it really a big stretch to conclude that this was a bubble? Was it so tough in 2005, when house prices had virtually tripled in ten years, to say we were in a real-estate bubble? Shiller got both calls right, and so did quite a few others. It’s not unreasonable to expect policymakers to identify bubbles, at least in their later stages.

And, on a broader level, what’s so difficult about the concept that developments in the financial sector, and, in particular, the rate at which banks create credit, has important implications for the over-all stability of the economy? From Adam Smith to Knut Wicksell to Hyman Minsky, many great economists have appreciated the perils of rampant credit growth, and unhinged finance generally. During the past few decades, though, all too many economists overlooked these dangers, or purposely sought to downplay them. Over time, these omissions helped to produce an intellectual environment in which policymakers from both major parties could pursue policies that proved disastrous.

One of the reasons for this failure in the market for economic analysis was the hegemony of the efficient-markets hypothesis, and the sunny view of finance it embodied. In choosing to honor Shiller and Fama at the same time, the Nobel committee has, wittingly or unwittingly, obfuscated this history. To prevent another policy disaster in the future, it needs telling and retelling.